S15 Q1vi - considerations for insurer INVESTING in bail-in bonds

[ativak]

1. under Basel III, are banks compelled to hold bail-in capital? If not, under what circumstances would a bank want to/need to raise bail-in capital? The answer to this question under the heading 'signalling' says: 'such bonds may signal internal concern on the part of the issuer, so indicate a low quality security' - what is the link between bail-in capital and internal concern?
2. high perceived risk due to uncertain term and yield due to risk of conversion/write-down - implies it has a high cost of capital -> is it more/less expensive to raise than tier 1 capital? And if more expensive, why does it rank below Tier 1 capital?
3. the answer has a section titled 'capital adequacy' - this section doesn't make any sense to me, especially the bit 'How does the bail-in bond count towards the insurer’s capital?' - if the insurer is investing in the bail-in bond, how could it count toward's the insurer's capital?

many thanks

 

[Colin McKee]

Hi
I don't think that there is any compulsion, and indeed the thrust of the solution seems to be (rightly) that a bank should not invest in these as it would exacerbate its problems in the event of a future banking crisis. Just at the point the banking industry is in trouble, the investing bank would find that its assets convert to lower ranking equity. In general, banks would issue these securities.
The comment on signalling maybe suggests that a banks decide to issue these only when they believe internally that a trigger might be a possibility in the near future. Otherwise why issue a bond that would have a very high interest rate, if there was little chance of having the benefit of it converting to equity.

The riskier the capital, the higher the cost. So equity would be considered to be the highest cost capital, and bonds that are only just subordinate to depositors would be considered the least risky and hence the lowest cost capital. Bail in bonds would be perceived as much riskier than standard bonds by investors and therefore have a higher rate. It would therefore cost a lot more for the issuing bank. When issued it would count as Tier 2 I suspect. But if the regulator triggers, they would downgrade to equity and therefore count as tier 1. Remember Tier 1 sounds like the top, but from an investors perspective it ranks the lowest (so its the bottom).

In terms of the final comment, I agree that its a complex one. I would have hoped to get close to the 8 marks on the more standard comments about the bond's return, its risk, tax treatment and accounting treatment etc. But when insurers make their Solvency II calculations, the assets they hold and the liabilities that the asset represent are linked together. (Same in banking actually - risk weighted assets are calculated using the "banking book" which notionally relates to the depositor liabilities, and the "trading book" which are the assets that notionally correspond to the free reserves and capital.) In insurance the same applies. If these bonds are inadmissible, then the capital allowable for the SCR would be reduced (even though capital is a liability, and the bond that the insurer has invested in is an asset).

 

[James789]

Hi Colin,

Is there actually anything on the liabilities side of a bank's balance sheet that is subordinate to depositors [from the perspective of a wind up]? I thought depositors were the lowest of the low? I know in the UK there is the FSCS guarantee, but that seems to be an additional 'overlay', so not technically related to the legal ranking of creditors, though I realise it would come into play in an insolvency.

Thanks!